RBI governor resigns: what is in store?

The governor of the Reserve Bank of India (RBI, the central bank), Urjit Patel, resigned on December 10th after several months of tensions between the bank and the government. His resignation will raise investor concerns about the central bank's independence. However, its longer-term impact will depend on how the government manages the transition to a new governor. We expect that, under new leadership, the RBI will loosen some of its regulatory norms, but the central bank's hawkish approach towards inflation-targeting is likely to endure.

Mr Patel's resignation comes ahead of a crucial meeting of the central bank's board, scheduled for December 14th, at which the government is expected to push for the RBI to loosen its approach toward the regulation of some banks facing high levels of bad debts. This is just one of several differences between the RBI and the government that have surfaced in recent months. These include a dispute over the government's demand for the central bank to dilute its prompt and corrective action (PCA) framework, which defines the parameters—such as the non-performing loan (NPL) ratio threshold—for intervention by the RBI in the functioning of a commercial bank. The government's contention is that the RBI's strict approach has contributed to a credit crunch, although credit growth has picked up pace in recent months.

The government has reportedly used its nominees to the RBI board to push for a relaxation in its regulatory stance. Adding to the tension is the fact that most of the banks facing high NPL ratios are state-owned, and are important lenders to key voter groups, such as small-business owners and farmers. These two factors are inter-related, as these banks face political pressure to lend to such groups, despite the high risk of non-repayment.

Raiding the bank

The government has also put pressure on the RBI to transfer to it a greater share of the surplus accruing from the central bank's operations. In a speech on October 26th Viral Acharya, an RBI deputy governor, criticised the government's alleged undermining of the bank's independence and argued that the RBI needed to maintain the strength of its balance sheet. The government's efforts to acquire the RBI's operational surplus are partly linked to its desire to bolster its fiscal position; data from the controller general of accounts show that the central government's fiscal deficit rose to US$91.2bn in January-October, from US$86.2bn in the same period of 2017.

The government is also reportedly concerned about the RBI's monetary policy tightening, and particularly about the impact that higher interest rates will have on consumers and businesses. Although the RBI has put tightening on hold at its last two policy meetings, tensions over its perceived hawkish stance have continued.

Volatility expected

Under its previous governor, Raghuram Rajan, the RBI bolstered its reputation for independence, a factor that helped to underpin international investor confidence in the Indian economy. This confidence has ebbed in 2018, driven partly by monetary policy tightening by the Federal Reserve (the US central bank), which has further reduced the interest-rate differential between the two markets. Capital outflows from India look set to accelerate in the short term. Mr Patel's resignation will add to uncertainty about the RBI's independence, which could result in a more dovish RBI approach to inflation-targeting. In the short term, therefore, the Indian rupee is likely to weaken against the US dollar.

The longer-term impact of the resignation will depend upon how the government and the RBI manage the transition to a new governor. In the interim, the senior deputy governor, N S Vishwanathan, is likely to assume temporary charge. The most damaging outcome for the RBI's credibility would be for a career bureaucrat to be appointed governor. Such a nominee would be particularly vulnerable to pressure from the government. Under such circumstances, there would be a substantial danger that the RBI could adopt a policy approach that prioritised short-term political benefit for the current government over the long-term health of the Indian economy.

An easing of regulation is in prospect

The RBI's regulatory mechanism for banks is likely to be eased in the coming months, as the government's pressure yields results in this sphere. Some welcome reforms will continue, however. Efforts to set up a public credit registry (a database containing information on borrowers that will aid creditors in their lending decisions), for example, are set to move forward. However, under a new governor, the RBI is likely to dilute some of the prudential thresholds under the PCA framework. This could have negative ramifications for the overall asset quality of the banking sector, which is already saddled with a worryingly high level of bad debt. According to the latest Financial Stability Report from the RBI, published in June, the banking sector's NPLs stood at 11.6% of total advances as of March 2018; the RBI expects this figure to climb to 12.2% by March 2019.

We do not expect the RBI's current inflation-targeting mechanism to be tampered with. Despite its concerns about the impact of higher interest rates on domestic demand, the government will be aware of the risk of a spike in inflation, which would also have political ramifications. Nevertheless, the loss of yet another governor—following Mr Rajan's early departure in 2016—will dent international investors' confidence in the government's economic credentials. We will adjust our forecasts for capital flows and the rupee's exchange rate in 2019 in view of the latest developments.